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2008 12

1 GM to announce a merger with another major auto manufacturer: 35%
2 More than US$25 billion to be injected into the big 3 auto-makers: 60%
3 Caroline Kennedy to replace Hillary Clinton in the US Senate: 53%
4 Guantanamo Bay Detention Camp to be closed in 2009: 84%
5 The US in Recession in 2009: 85%
6 An air strike against Iran before end of 2009: 21%
7 US unemployment rate at or above 8% in December 2009: 50%
8 Robert Mugabe to depart as President of Zimbabwe in 2009: 50%
9 Slumdog Millionaire to win Academy Award for Best Picture: 52%

Robert Lucas, an economist and Nobel laureate at the University of Chicago and a champion of the rationality of markets, doesn’t see much fundamental change coming out of the crisis, either. What it has reminded us of, he argues, is simply the impossibility of seeing these events in advance.

“I don’t know anybody involved who thought he could predict these turning points. Do macroeconomists know as much as we thought we did?” he asks. “Of course not.”

By this logic, the problem isn’t how economists see the world so much as it is what we expect of economics.

Alan Greenspan, interviewed in Die Zeit, on the effectiveness of monetary and fiscal policy:

Global forces can now override most anything that monetary and fiscal policy can do. Long-term real interest rates have significantly more impact on the core of economic activity than the individual actions of nations. Central banks have increasingly lost their capacity to influence the longer end of the market. Two to three decades, ago central banks were dominant throughout the maturity schedule. Thus, the more important question is the direction of long-term real interest rates…

The resources of central banks relative to the size of global forces have markedly diminished. We have 100 trillion dollars of arbitragable long-term securities in the world today so that even large movements initiated by central banks have little impact. Until the seventies, central banks and finance ministries were able to hold exchange rates fairly stable. Since then, the ability to intervene in the exchange markets and stabilize the rates has gone down very dramatically. And that is also true for other financial markets. Global forces fostering global equilibrium have become by far the most dominant influence for financial and economic activity. Governments have ever less influence on how the world works.

“Zoos and aquariums are woven into the fabric of American life,” said AZA President and CEO Jim Maddy. “They are viewed by the public as important to the quality of life in their communities.”

Many zoos have their roots in the Great Depression, when the Federal Work Projects Administration (WPA) helped build many zoos across America.

“Zoos and aquariums will deliver incredible value for the Federal government,” added Maddy. “Investment in these institutions will pay-off twice, first in immediate job creation, and second, in the environmental education of our children for years to come.”

The same children can also look forward to paying for them for years to come.

Come to think of it, I also have some ‘shovel-ready’ projects in my backyard that could do with some stimulus.

Tyler Cowen suggests the historical record argues against the effectiveness of fiscal stimulus:

it is very hard to find examples of successful fiscal stimulus driving an economic recovery. Ever. This should be a sobering fact…

It’s up to the advocates of the trillion dollar expenditure to come up with the convincing examples of a fiscal-led recovery. Right now we’re mostly at “It wasn’t really tried.” And then a mental retreat back into the notion that surely good public sector project opportunities are out there.

So what you have is the possibility of faith—or lack thereof—that our government will spend this money well.

And that is under “emergency” conditions, with great haste (“use it or lose it”), with a Congress eager to flex its muscle, and with more or less one-party rule.

Another way of looking at this issue is to ask why we would ever need to experience a significant economic downturn if policymakers could effectively smooth the business cycle with fiscal policy.

Meanwhile, Centrebet is offering $1.22 for a local recession by the December quarter 2009. Assuming an 8% bookie’s margin, this implies a recession probability of around 75%. Needless to say, the Treasurer is not happy with betting shops speaking truth to power:

John Taylor debunks the myth that failing to bailout Lehman Brothers was responsible for the subsequent intensification of the global financial crisis:

Many commentators have argued that the reason for the worsening of the crisis was the decision by the U.S. government (more specifically the Treasury and the Federal Reserve) not to intervene to prevent the bankruptcy of Lehman Brothers over the weekend of September 13 and 14.

The [LIBOR-OIS] spread moved a bit on September 15th, which is the Monday after the weekend decisions not to intervene in Lehman Brothers. It then bounced back down a little bit on September 16 around the time of the AIG intervention. While the spread did rise during the week following the Lehman Brothers decision, it was not far out of line with the events of the previous year.

On Friday of that week the Treasury announced that it was going to propose a large rescue package, though the size and details weren’t there yet. Over the weekend the package was put together and on Tuesday September 23, Federal Reserve Board Chairman Ben Bernanke and Treasury Secretary Henry Paulson testified at the Senate Banking Committee about the TARP, saying that it would be $700 billion in size. They provided a 2-1/2 page draft of legislation with no mention of oversight and few restrictions on the use. They were questioned intensely in this testimony and the reaction was quite negative, judging by the large volume of critical mail received by many members of the United States Congress. It was following this testimony that one really begins to see the crises deepening, as measured by the relentless upward movement in Libor-OIS spread for the next three weeks. Things steadily deteriorated and the spread went through the roof to 3.5 per cent.

…identifying the decisions over the weekend of Sept 13 and 14 as the cause of the increased severity of the crisis is questionable. It was not until more than a week later that conditions deteriorated. Moreover, it is plausible that events around September 23 actually drove the market, including the realization by the public that the intervention plan had not been fully thought through and that conditions were much worse than many had been led to believe. At a minimum a great deal of uncertainty about what the government would do to aid financial institutions, and under what circumstances, was revealed and thereby added to business and investment decisions at that time. Such uncertainty would have driven up risk spreads in the interbank market and elsewhere.

Taylor doesn’t say it, but his event study is also consistent with the view that it was irresponsible scare-mongering by the US authorities in support of the TARP legislation that was responsible for the subsequent blow-out in the LIBOR-OIS spread.

The list of big-name economists, commentators and forecasters who hung their hats—and their investment plans—on variations of peak oil theory is too big for this page, but some day somebody should post it prominently for all to see.

One of the rare exceptions, a name not on any such list, is Vaclav Smil, perhaps one of Canada’s greatest unsung academics. Let me now sing his praises. Prof. Smil is a distinguished professor in the environment faculty at the University of Manitoba. One of his many books, usually dense and written for scholars, is a new popular Beginners Guide, simply titled Oil (Oneworld Publications, 200 pages, 2008).

Back in June, 2006, Prof. Smil wrote a commentary for FP Comment dismissing the peak oil crowd as a “new catastrophist cult.” In 2000, he warned in a science journal that the experience of long-range forecasting, especially in energy, had been dismal. He predicted more. “There will be no end to naive, and ... incredibly short-sighted or outright ridiculous, predictions.”

Prof. Smil’s new contribution to the absurdity of peak oil theory, Oil, is more than just a critique of the latest crackpot forecasting theories. In 200 pages, he packs everything most people—including most economists and investment advisors—should know about the physics and economics of oil.

As time goes on the world will slowly sever its dependence on fossil fuels, but any such transition is decades away. Peak oil enthusiasts are wrong for scores of reasons. They assume that oil reserves are know with some degree of precision; that reserves are fixed; that demand and supply can be projected with accuracy over long periods of time.

As Prof. Smil wrote on this page in 2006: “Unless we believe, preposterously, that human inventiveness and adaptability will cease the year the world reaches the peak annual output of conventional crude oil, we should see that milestone (whenever it comes) as a challenging opportunity rather than as a reason for cult-like worries and paralyzing concerns.”

The current differences in the interest rates of euro-zone government bonds show that the financial markets regard a break-up as a real possibility. Ten-year government bonds in Greece and Ireland, for example, now pay nearly a full percentage point above the rate on comparable German bonds, and Italy’s rate is almost as high.

There have, of course, been many examples in history in which currency unions or single-currency states have broken up. Although there are technical and legal reasons why such a split would be harder for an EMU country, there seems little doubt that a country could withdraw if it really wanted to.

The most obvious reason that a country might choose to withdraw is to escape from the one-size-fits-all monetary policy imposed by the single currency. A country that finds its economy very depressed during the next few years, and fears that this will be chronic, might be tempted to leave the EMU in order to ease monetary conditions and devalue its currency. Although that may or may not be economically sensible, a country in a severe economic downturn might very well take such a policy decision.

Intrade puts the probability of an existing member leaving the eurozone before the end of 2010 at 27%.

The Lion Rock Institute and International Policy Network have published a report by Bill Stacey and Julian Morris on How Not to Solve a Crisis. I agree with their assessment of the failure to bail out Lehman Brothers, which runs counter to the conventional wisdom:

The Lehman bankruptcy followed on 15 September, after talks with a few parties about a buyout failed. Early talks apparently failed because management held out for a higher price. Later talks failed because the government refused the guarantees sought by potential purchasers. The consequences of failure were large, with unsettled trades and frozen collateral disrupting markets everywhere. The Bear precedent had led many market participants to believe that Lehman would not be allowed to fail. Markets quickly priced the swing in policy, leaving all securities companies vulnerable.

The popular view among market participants is that Lehman should not have been allowed to fail. Yet if Bear had not earlier been rescued, Lehman would likely earlier have raised funds, counterparties would have more quickly protected themselves from risks and underlying problems would have been recognized sooner.

RESERVE Bank governor Glenn Stevens last night flagged further interest rate cuts to help shore up the economy.

The AFR:

Reserve Bank Governor Glenn Stevens has signalled the bank’s unprecedented series of deep interest rate cuts may have come to an end.

Both papers fell victim to the view that every time the Governor speaks, he must be sending a signal on interest rates and if there is no explicit signal, then there must be an implied one. In fact, the RBA very rarely signals its policy intentions, not least because its view on the future direction of policy is not very strongly held. Unlike the rest of us, the RBA doesn’t need to anticipate its own actions, putting more value on policy flexibility than policy predictability.

I have an op-ed in today’s Age, highlighting the Ricardian and open economy macro arguments against using fiscal policy for demand management:

From the perspective of national saving, it makes no difference whether an increase in government spending comes out of the budget surplus or whether the government goes into deficit and borrows from capital markets. Either way, the government is saving less.

But this doesn’t mean that households will follow the government’s example. In fact, households are likely to save more in anticipation of a higher future tax burden due to the reduction in government saving…

Demand management is best left to the Reserve Bank and monetary policy, which has already responded aggressively to a slowing economy.

The sharp decline in the Australian dollar exchange rate is also a powerful stimulus to net exports, but any boost to demand from fiscal stimulus will also have the perverse effect of putting upward pressure on the exchange rate, reducing net exports. In an open economy, there is no free lunch from fiscal policy.

Fiscal policy still has a role to play in supporting economic growth, but it needs to focus on long-run structural and supply-side issues not short-term attempts at rigging aggregate demand.

This means rewarding labour force participation, not encouraging welfare dependence. Throwing more money at pensioners and families will not boost economic growth in the long-run and may not work as the government intends in the short-run.

In The Australian, Henry Ergas makes a similar argument against proposals to use superannuation contributions as a macroeconomic stabilisation instrument:

Consumption decisions are shaped not by transient changes in income but by expectations of income going forward, a proposition known as the permanent income hypothesis. A short-term reduction in compulsory savings, soon reversed and followed by a sequence of rapid increases in mandatory contributions, amounts to a pre-announced reduction in disposable incomes. As households respond to the news that their disposable incomes will fall once the temporary cut is reversed, consumption is likelier to decline than to increase.

My Age piece may have fallen victim to a which-hunt. This line should read:

‘The household saving ratio has already surged from 1.3% in the June quarter to 3.9% in the September quarter. This implies that taxpayers squirreled away their 1 July tax cuts, which came at the expense of the budget surplus rather than cuts to government spending. ‘

Westpac crunches the numbers on the household income account, with some predictable results:

All up, the total fiscal boost to household disposable income in Q3 was about $1.9bn. This was mostly due to $7.1bn in income tax cuts, which equates to $1.8bn a quarter. The boost appears to have done little or nothing to stimulate consumer spending in Q3. Indeed, with aggregate household savings rising by $4.4bn in the quarter, the implication is that, in aggregate, households saved all of the windfall and then some. Most of the savings appears to have gone towards paying down housing debt.

The national accounts figures and RBA credit data imply that households injected an enormous $7.5bn into their housing equity in Q3, most of which would have been via paying down principal. This is only the third net equity injection recorded since June 2001. It is easily the largest ever in dollar terms and is the biggest as a proportion of income since 1998Q3. If Q3 is a guide and households remain as deeply concerned about reducing their debt levels in the months ahead, the implication is that there will be little or no boost from policy stimulus in Q4.

Westpac nonetheless thinks Q4 might be different, on the basis that saving all the stimulus in Q4 would be ‘too extreme’, but unprecedented times are likely to induce unprecedented responses as households anticipate a higher future tax burden.

The Australian economy expanded 0.1% in the September quarter, which is dismal enough, but non-farm GDP contracted 0.3% over the quarter. Farm output rose 14.9% over the quarter. In current prices, the increase was only 7.5%, but the price deflator for farm GDP fell 6.5% over the quarter.

This points to a little appreciated aspect of the relationship between commodity prices and the Australian economy. High commodity prices are often the flip side of weak commodity production, which depresses real GDP growth. To the extent that lower commodity prices reflect increased output, this is actually a positive for real GDP growth.

As I argue in a forthcoming article in Policy, commodity prices are far less important to economic growth in Australia than conventionally assumed.

The consensus forecast for September quarter GDP growth to be released on Wednesday is 0.2%, with growth through the year seen at 1.9%. Market forecasts range from -0.3% q/q to 0.5% q/q. Dusting off the old top-down GDP model, I also get 0.2% q/q.

Growth would then have to accelerate slightly to 0.3% in the December quarter to be consistent with the RBA’s year-end forecast of 1.5%. That may be a tall order given what is happening both domestically and globally, but by no means impossible.

The market is expecting a 75 bp reduction in the official cash rate to 4.5% tomorrow. With the RBA’s forecast for underlying inflation for the December quarter at 4.5%, the real cash rate will effectively be zero.